AGB 2021.13 - Five Below (FIVE)

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Jun 28, 2021

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Five Below

“At the end of the day, it's a fun store, and we want to be the yes store, we want to be a store that customers love to come in and just let go and have fun in.” – Chief Executive Officer, Joel D. Anderson on the F18Q3 Earnings Call

Five Below is the leading value retailer of discretionary goods targeted specifically at tweens and teen customers in the U.S. Most items are priced in the $1-$4 range (60% of items sold) and as the name suggests, below $5 (though that number has moved higher to $5.55 recently). The company operates over 1k stores in 38 states.

The average customer spends about 10-20 minutes in the store, purchases goods totaling $15 and makes roughly 10 visits per year to a Five Below location. The company estimates that roughly half (52%) of shopping visits to the store are planned and the other half (48%) are visits after stopping by other stores within a shopping center. The customer comes from a household with $80k in annual income, roughly double that of a dollar store customer. As of the last census, 63M people in the U.S. are between the ages of 5 and 19 or roughly 20% of the population.

Five Below stores purposely have a layout to encourage a “treasure hunting” shopping experience, divided into 8 worlds: Style, Room, Sports, Tech, Create, Party, Candy and Now. Each of these has an assortment of goods that are turned over with high velocity. A typical store has 4k SKUs (much lower than a Dollar Tree, which has 7k SKUs) but it’s estimated that a store may go through 10k-12k SKUs in a single year. The idea is to encourage multiple trips to the store throughout the year to discover what’s new that’s offered in store.

The closest competitor to Five Below is likely Dollar Tree (though at a much lower price point at $1) and Dollar General’s Popshelf concept (12 stores in a few states) in the U.S. given the mix of discretionary vs. consumable items offered in these stores. You can read our Dollar General report here. A Five Below store does about $2M in revenues annually, though that number should be higher in FY21 after recovering from the impact from Covid. Dollar Tree by comparison does about $1.7M in revenues/store.

The growth story at Five Below is mainly from new units, which have best in class ROIs. Over the past 10 years, revenue growth from same store sales, which is defined as stores that have been open 15 months (this also includes stores that are open during remodel and relocations that are of similar size) account for 3.3% of the growth, while new stores account for 23.1%.

Five Below is slated to open 170-180 new stores in FY21, all funded with cash on hand, due to the high returns and low payback period. A new store is typically 9k in sq ft and resides in urban, suburban and semi-rural markets typically in a strip mall or outdoor shopping center. New stores have been increasing in size ever since FY15 when the company started to experiment with different layouts, a larger front checkout area, and most recently adding a new section in the store called “Five Beyond”.

Merchandising is an important part of the Five Below concept because the freshness and trendiness of the products and the marketing related to these products is what drives customers to the stores. Because Five Below needs to have quick turn around on new trends (like fidget spinners in 2017), 60% of the company’s vendors are based in the U.S.

Why is it a good business?

Similar to many other retail concepts, Five Below benefits from more scale advantages as the company grows. At the store level, the company is more efficient with supply chain/distribution and opening costs. At the corporate level, the company can do more with merchandising and increase overall brand awareness.

As mentioned before, merchandising is an important part of Five Below’s competitive advantage. 40-45% of products offered are exclusive to Five Below and 1/3 is private label, which commands much higher margins. The low price points and treasure hunting shopping experience means that customers don’t price shop as much.

Due to scale and working with vendors to reinvest back into quality products, Five Below has been able to offer better goods for the same $5 price point. This is a unique challenge to fixed price discount retailers (Dollar Tree included) because it’s difficult to improve on product quality if you can’t easily pass down the extra costs to the end consumer. The example the company likes to use is R/C cars offered at the time of IPO for $5, two years later became an infrared helicopter, which then two years after that became a branded copter and by 2019 was a micro R/C quadcopter. By 2020, customers can buy a Wi-Fi drone with camera for $10 in the Five Beyond section of the store.

On the brand awareness front, the company estimates that stores that are open less than 2 years have 32% brand awareness in that local market while stores open 8+ years have 62% awareness. Interestingly, trends like fidget spinners also build brand awareness even after the craze is over, because it introduces new customers to the store. Advertising dollars are much more effective as the company can start to leverage national level advertising vs. just local print and radio ads. Goldman has a nice chart of ULTA and EYE reducing their advertising as a percentage of sales after introducing national advertising.

Five Below has also seen similar efficiencies with TV advertising. The company started off advertising with print circulars (on average 15x per year) and moved into TV advertising in 2014. Since then, the company has increased the percentage of stores covered under TV advertising from 25% to over 40% during the holiday season. The company also introduced digital advertising and even partners with influencers to promote the Five Below brand. By F20Q4, Five Below didn’t do any print circulars and had 25% of their stores under TV coverage and 90% under digital.

What’s probably the most impressive thing about Five Below is the company’s ability to reach high productivity for new stores in the first year. New stores reach 90+% productivity in the first year consistently across geographies and by class.

The drawback to this is that there is less of a natural comp benefit in year 2 because there’s less than 10% productivity left for new stores to achieve to get to the average store revenue level. Another way of looking at it is that comp store sales growth for Five Below is understated vs. other fast growing retailers.

The pessimistic view of such high new store productivity could be that (1) most of the goods sold are discretionary (and trend following), (2) Five Below doesn’t build a lasting shopping habit with customers to purchase certain goods (like grocery and other consumables) or (3) the customer demographic (tweens and teens) grows out of wanting to shop at the store over time.

The optimistic view could be that (1) the company is good at preopening marketing, supply chain and deploying learnings from past experiences quickly into their new stores, or (2) new stores have been increasing in size since the time of IPO (7.5k sq ft to 9k sq ft) which can skew the new productivity number higher.

The revenues/store consistency across regions and stores is impressive and it’s a reflection of how good the company is at ramping up the new stores up to the company average. And looking at comp store sales trends, we can see that comps have increased over 3% annually over the past decade and that the average ticket is moving higher, implying customers are purchasing more goods every year.

If the company experiments with a loyalty program and/or a credit card in the future, Five Below has an opportunity to do more targeted marketing as it collects more relevant customer data.

Returns on capital?

Over the past 10 years, Five Below has spent over half of its capex on building out new stores, 35% on its distribution network and 12% on corporate and IT expenses. Capex related to store build outs are consistent, averaging $300K from FY12 to FY19 and just recently moved higher to $400k in FY20. While we’re not certain why the costs have gone up in the past year, it may have to do with larger locations (adding a Five Beyond section in the back) and higher material and start-up costs. The company funds all of its capex needs from operating cash generated and hasn’t had debt on the balance sheet since FY13.

If a new store costs between $300k-$400k and contributes anywhere between $450k to $500k in EBITDA, it implies a pre-tax return on capital of 125%-150% and a payback period of less than a year. Credit Suisse has a nice breakdown of four-wall ROIs across the retail landscape (from 2018) and Five Below stands out for having a high ROI and low payback period. Compare this to Dollar Tree which has a four-wall ROI of 55% and a payback period of less than 2 years.

The company also spends its capital on incrementally improving its store base over time. Five Below’s recent remodeling program started in 2017, adding more toys to the selection (filling a void from the Toys R Us bankruptcy), associate assisted self checkout, a separate Five Beyond section at the back of the store and brighter lighting and signage. The company remodeled 30-50 stores per year since the start of the program and expects to remodel 300 stores over the next few years.

The company has stated that the cost to remodel is roughly half of a new store build out (so assume $150k) and the payback period is less than 3 years. These stores get a mid-single digit comp lift after the first year after the remodel, which implies a $100k-$115k lift in sales and at 36% gross margin, implies a $36k-$41k lift in store level earnings. The incremental gross margins on items sold is actually higher since 25% of COGS is fixed. This would imply $52k-$57k in lift in store level earnings, which reconciles with the less than 3 year payback period, but we have to remember that this is a pre-tax calculation. There are also added depreciation expenses from the remodels, which adds to the cash returns.

For the capital spent on its distribution centers, it would be difficult to run the same ROI exercise. But it’s worth noting that the investments have been ramping up for these distribution centers over the past three years ($32M in FY18, $102M in FY19 and $94M in FY20). The company currently has DCs in New Jersey (1M sq ft), Texas (860k), Georgia (700K) and Mississippi (600k) and is building one in Arizona (860k) which is slated to open in 2021.

We estimate that Five Below has returned between 50%-60% on its capital over the past 5 years (with the exception of FY19, which was due to a large inventory stock up as the company started building out more distribution centers). While the return on capital is high, we note that it’s lower than the store level ROI due to the other capex line items, corporate expenses and taxes.

Reinvestment potential?

At the company’s IPO, the targeted store opportunity in the U.S. was 2k. We have to keep in mind that at this time, Five Below had just over 200 stores and was only in 17 states. The company hadn’t entered Texas or California, which are the largest expansion opportunities today. In January 2017, the company revised that number higher to 2.5k+, which could ultimately get revised higher again in the future. We have to remember that other value retail concepts like Dollar Tree has almost 8k locations and Dollar General has over 17k.

In FY16, the company laid out a 20/20 by 2020 plan, which is average sales and net income growth of 20% by 2020. Five Below wasn’t able to achieve that (ended up at 18.7% revenue growth over 5 years) due to the impact from Covid in FY20, but the company almost did so by averaging comp store sales growth of 1.5% and non-comp store sales growth of 17.4%.

In terms of new store count, the company has averaged 20% net new store count growth from FY15 to FY19 and dipped below that in FY20 to 13%. For FY21, the company expects to open 17% net new stores at the midpoint, which signals somewhat of a slowdown. Assuming that the company maintains a 17% growth rate for new store openings, Five Below would reach its target of 2.5k stores by FY26, or just 6 more years.

When expanding its store base, the company has a different strategy depending on whether a Five Below store already exists in that market. For existing markets, the company takes on a densification strategy, which leads to advertising, operating and distribution efficiencies. And typically, the cannibalization impact is 100bps of comp, which is minimal compared to the new revenue and EBITDA generated. Advertising efficiency is likely the highest impact as TV advertising generates better returns the higher the store density.

When entering new markets, the company likes to deploy a store clustering strategy, which is opening many stores in a single market on the same day. This means that the company can more efficiently leverage marketing and advertising costs (circulars, digital and TV) and help keep preopening expenses lower.

Another area of reinvestment opportunity is in new concepts that the company can partner with for its stores. In 2019, Five Below led a Series A financing round for Nerd Street Gamers, an e-sports facility and event management company, and partnered with the company to build dedicated e-sports facilities. The company is also testing Nerd Street local hosts, which is Five Below’s store-in-store format. Customers can come try out pro-level gaming equipment in store.

With a reinvestment rate between 30%-40%, we estimate that Five Below’s intrinsic value has increased 18%-20% annually over the past 5 years. Even with an unlevered balance sheet, the company has been able to keep reinvestment high enough to be one of the fastest growing concepts in retail.

What else is important?

Covid impact

Covid had a big impact to Five Below because its stores were not considered essential and had to close in many states. Stores closed on March 20, 2020 and began reopening at the end of April that year. During that period, employees were furloughed, management and salaried employees took temporary pay cuts, and the board wasn’t paid. The company quickly changed or delayed receipt of orders from its vendors to manage inventory and reduced its capex plan, ultimately reducing the number of stores it opened from 180 to 100-120. The company ended up opening 120 net new stores in FY20.

When it was time to reopen, Five Below was well prepared as it had all the right assortment of inventory for early summer and skipped all the merchandise related to Easter. Product mix also shifted to more essential goods including consumables, food and drinks, fitness and work from home products. Again, the company showed that its merchandising ability is top notch in the industry.

Ecommerce

Because Five Below depends on the treasure hunting experience in-store, ecommerce has been less of a focus for the company. Starting in August of 2016, the company launched fivebelow.com, offering a small selection of items. The company considers the online store as a convenient way to shop at Five Below if that’s important to the customer. There are no concessions on shipping costs (usually $5) even if the basket size meets certain thresholds.

The impact from Covid did show the company that an ecommerce platform could be valuable. While stores were closed, customers still were able to order online. The company accelerated the development of its mobile app and brought on the partnership with Instacart for same day delivery.

Interestingly, the online store contributed to half of the 8% comp increase when stores first reopened in F20Q2. At a very low penetration rate (less than 3% of total sales), it would imply that the ecommerce channel was growing 200+%. Ultimately the company needs to figure out how the ecommerce platform will compliment the in-store experience. Another good thing about the ecommerce platform is that the company has customer information for the first time (because they have no loyalty program or a cobranded credit card).

Optionality

Geographic expansion / Canada, Mexico, etc.

The company has yet to test other markets and competitive positioning will be different in other countries, but it wouldn’t be a surprise if they started to target these markets once the company has expanded throughout most of the United States. This is where the 2.5k+ store opportunity can move much higher.

New concepts like Five Beyond

If the company gains traction for its Five Beyond concept in its stores, it might be worth spinning it out to stand alone Five Beyond stores. At prices ranging between $5-$15, the company can target a higher price point while not risking cannibalization of its core market.

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